Let us understand why with the help of a coin toss example
Heads - You win Rs. 10,000
Tails - You lose Rs. 10,000
Would you take this bet?
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Heads - You win Rs. 10,000
Tails - You lose Rs. 10,000
Would you take this bet?
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Most of us would NOT!
Why?
Because, the psychological impact of losing Rs. 10,000 is much stronger than the benefit of winning Rs. 10,000.
This tendency is referred to as ‘loss aversion’.
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Why?
Because, the psychological impact of losing Rs. 10,000 is much stronger than the benefit of winning Rs. 10,000.
This tendency is referred to as ‘loss aversion’.
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Now, if the original bet is restructured a bit where the benefit of winning is increased, more people will be winning to take the bet.
For eg:
Heads - You win Rs. 20,000
Tails - You lose Rs. 10,000
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For eg:
Heads - You win Rs. 20,000
Tails - You lose Rs. 10,000
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Behavioural psychologists Amos Tversky and Daniel Kahneman conducted a series of experiments on loss aversion and concluded that the gain to loss ratio needed to be at least 1.5x to 2.5x for people to participate in such a gamble.
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Simply put, Loss aversion is a cognitive bias that describes why, for individuals, the pain of losing is psychologically TWICE as powerful as the pleasure of gaining.
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When equity markets continue to go up, our inbuilt loss aversion tendency makes us fear the possibility of a decline much more than the possibility of further gains.
Therefore, we tend to get anxious in anticipation of declines!
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Therefore, we tend to get anxious in anticipation of declines!
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So, how do we keep the loss aversion tendency from affecting our investments?
1. Focus on the long term: In the last 40 years, while Indian equity markets have seen SEVEN big temporary declines > 30%.....
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1. Focus on the long term: In the last 40 years, while Indian equity markets have seen SEVEN big temporary declines > 30%.....
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....they eventually recovered to hit new highs and long term returns have mirrored the underlying earnings growth.
2. Stick to your asset allocation and rebalance if the allocation deviates by more than 5%
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2. Stick to your asset allocation and rebalance if the allocation deviates by more than 5%
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3. Have a predefined plan for Bubble markets and Bear Markets
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